Is the Basel process broken? You can count on it

From The Conversation comes the following critique of the Basel Capital Adequacy Framework by Pat McConnell, Honorary Fellow at Macquarie University’s Applied Finance Centre.

This year, the Basel process of banking regulation is 25 years old. In 1988, the first set of global banking regulations, known as Basel I, was adopted by the world’s senior banking regulator, the Basel Committee on Banking Supervision (BCBS), which is based in the Swiss city of the same name. There have been three major (and a few minor) iterations of Basel proposals since 1988: Basel II in 2004 and Basel III, which was approved in 2010 after the GFC but revisited only this week.

Pronouncements from the Basel Committee tend to be written in impenetrable, bureaucratic jargon. For example, the latest announcement is titled “Group of Governors and Heads of Supervision endorses revised liquidity standard for banks”. It could just as easily been labelled “After talking about this for two years, we have given into the banks, yet again”. To use the terminology of the ‘fiscal cliff’, regulators have “kicked the can” down the road, postponing final implementation of a critical component of Basel III, the so-called liquidity coverage ratio (LCR), until 2019 – a lifetime in the financial markets.

Before discussing this latest climb-down, it should be noted that the Committee has form in this respect.

A short history will illustrate how the Basel process has evolved. The first Basel proposal was relatively benign, requiring banks to maintain minimum levels of regulatory capital at a ratio of 8% of their credit risk- weighted assets. This meant that for each $100 of loans, banks had to retain $8 dollars against potential losses. This figure of 8% was arrived by a tortuous committee process that was far from transparent. After agreement, it was decreed that the banks covered by the initial rule would comply over a three-year “transition” period.

One might ask: why would implementation take three years?

Even though the calculation of the minimum capital required was — in the Committee’s own words — “simple”, in practice banks were forced to develop new computer systems and accounting processes to collect the data needed to do the relatively straightforward calculations. This scenario of rule-making, followed several years later by partial implementation is a recurring theme of Basel regulations.

In its first iteration in 1988, Basel I applied only to traditional assets, such as loans, which were “on balance sheet”. “Off-balance sheet” items such as currency and interest rate derivatives were not considered. In 1995, however, the venerable British bank Barings collapsed. Regulators were shocked to discover that these new-fangled derivatives could actually bring down a functioning bank. Reacting late as usual, the Committee hurriedly proposed a new set of rules on the capital required to cover so-called “market risks”.

In 1996, the so-called Market Risk Amendment to Basel I was agreed by the Committee with a new concept, known as value at risk (VAR), embedded in the regulations. The concept of VAR has been the subject of much debate in the academic literature as to its usefulness as a robust measure of risk. Of concern was that fact that VAR does not give a reliable indication of what can occur in an extreme “black swan” situation. However, despite the obvious drawbacks, VAR became the standard for calculating market risk capital, with disastrous consequences later.

The 1996 Amendment marked a seachange in banking regulation that was not fully apparent at that time. In addition to decreeing a supervisory formulae for each type of derivative (the “standardised model”), the Committee introduced a new concept — the “internal model” — by which a bank could use its own internal calculations to estimate the capital that they needed. In other words, the inmates (i.e. the largest banks) had been allowed to take over the asylum, or at least the Basel capital calculation process. Regulators moved from their traditional role of setting strict limits on banking activity to becoming mere checkers of banks’ own internal models. This was an arms race that regulators were always going to lose, as banks had more money than regulators to buy computers and hire rocket scientists (literally) to develop mind-boggling mathematical models, which, as the GFC illustrated, often worked poorly in practice.

In 1999, the Basel Committee announced plans to introduce a new capital adequacy framework, which became known as Basel II. The Committee argued that Basel II was necessary because the banking industry had developed risky products that were not covered by Basel I. Boy, were they right!

For the next five years, the Committee toiled to agree on Basel II rules and, in 2004, produced the “revised framework“, a 239-page document that is utterly incomprehensible, filled with complex formulae for which no theoretical underpinning was ever provided. After four more years and billions of dollars spent complying with new rules, Basel II was implemented in 2008 in some of the world’s largest banking markets. Interestingly, the USA was not one of them.

But by the time that Basel II was finally implemented, it was already too late. Basel II was overtaken by the global financial crisis (GFC), which was exactly the type of credit-related calamity that Basel was meant to prevent. The Basel capital regime failed as supposedly well-capitalised banks (at least according to their own models) had to be bailed out by taxpayers and sovereign wealth funds. All sorts of risks that had been excluded from Basel rules — such as liquidity risks — had torpedoed some of the largest banks in the world, costing taxpayers billions.

Basel was not responsible for the GFC, but it was as useful as an umbrella in a hurricane. During the crisis, when it should have been in the forefront of efforts to tackle the crisis, the Basel Committee was missing in action, while bodies such as the G-20 and the IMF rolled up their sleeves to tackle the problems caused by the obviously insufficient banking regulations developed in Basel.

When the hubbub died down, the Basel Committee did what it does best, which was to issue new rules to fight the last war. In 2010, the Committee unveiled Basel III, which in itself is not an unreasonable set of rules to force banks to maintain capital to cover an increased range of risks such as liquidity risks. Unfortunately, Basel III still does not address some of the key root causes of the GFC, such as the shadow banking problem, or what to do about firms such as hedge funds, whose activities can undermine regulated banks.

What is really depressing about Basel III, is that, before the ink has even dried on the new rules, the world’s largest banks, aided often by their own governments, have found ways around the new rules. Australia is a good example.

During the GFC, a number of failed banks, such as Northern Rock and Lehman Brothers, ran out of ready cash to pay the bills – in banking terms, they lacked liquidity. One of the more sensible rules in Basel III is for banks to be forced to maintain sufficient highly liquid assets (HLA), such as government bonds, to tide them over a crisis. The idea is that banks could, in a crisis, sell HLAs to keep them going for about one month, or at least long enough for the government to come up with a plan to bail them out.

So far, so good. But nothing is as easy as it seems, at least where Basel is concerned. Due to successive governments’ aversion to issuing government debt there is, in Australia, a distinct shortage of high-quality HLAs. So what to do? Should we force Australian banks to cut back their highly profitable activities today to comply with foreign banking regulations?

Enter the Reserve Bank of Australia (RBA). In a recent speech, Assistant Governor Guy Debelle described a rabbit, the so-called committed liquidity facility (CLF), that had been neatly pulled out of the RBA’s hat. Stripped of technical twaddle, the CLF means that the taxpayer (in the guise of the RBA) will act as pawnbroker to the big banks when they are short of readies, taking whatever dross they have on their books and giving them cash to tide them over. With backing like that and the promise of an implicit government guarantee, is it any wonder that Commonwealth Bank’s market capitalisation has just topped $100 billion, pushing it into the list of top 10 banks by market capitalisation in the world?

If Australia is prepared to bend the rules to protect the profitability of the biggest banks, what can be expected of less trustworthy jurisdictions?

After 25 years, it is about time that the question was asked: is Basel doing a good job, and is that job worth doing?

The history of Basel shows that the process of developing robust regulations to prevent international banks failing is broken. The Basel process lacks transparency and accountability and has been captured by the very firms and governments that it is trying to regulate. It is based on inexplicable agreements that are arrived at through a convoluted committee process, producing results that take several years and millions of dollars to implement. The Basel bureaucrats are not evil or incompetent, but are simply outgunned by the bankers, who can afford to keep lobbying until rules are watered down and implementation is delayed.

Basel is broken. We needn’t wait until 2019 — or another GFC — for this to be confirmed.

32 Responses to “ “Is the Basel process broken? You can count on it”

  1. littleguy says:

    This isn’t going to end well, is it?

    • [email protected] says:

      SMOKESTER
      red alert

  2. MsSolarFelineAU says:

    Every thing is broken. We, ourselves, as Sovereign Individuals, need to be our own Central Bank.

  3. Peter Fraser says:

    I’m quite happy to see a formal arrangement so that we all know the RBA will stand behind the licenced Australian banks.

    We all knew they would, so it may as well be spelt out.

    • General Disarray says:

      How much would be a fair price for this backing?

      • Peter Fraser says:

        Interesting question – it certainly has a value. I know that Glen Stevens had something to say on that, as did CJ and a number of others.

        I don’t recall exactly how they calculated the monetary value or what they claimed it was worth, but whatever the cost is – it would be passed onto you and I anyway, so it’s a rob Peter to pay Paul situation if you need banking arrangements at all.

      • General Disarray says:

        It’s a strange situation. The public who are on the hook for any failure end up paying any fees the banks are charged for this protection.

        Interesting times.

      • Peter Fraser says:

        It’s a thing of beauty really, you have to admire it.

        Every successful business passes on all its running costs, and then some. That is how they make a profit, and that is why they are successful.

        But it’s still a thing of beauty, dollar art if you prefer.

      • GSM says:

        Beauty? Hardly, more like an abomination. The Banksters get to play in the casino while the public are press ganged into backing them against excessive losses.

        It’s one thing to pass on losses. Quite another to have the RBA and Govt running a protection racket on your behalf.

      • Peter Fraser says:

        A. Where is your sense of humour?

        B. All business must pass costs on – business school 101.

      • Peter Fraser says:

        It’s an error I enjoy.
        Perhaps it’s my small town upbringing.

      • dillegance due says:

        “It would be passed onto you and ME anyway”.
        Your sophistry deserves better grammar.

  4. Diogenes the Cynic says:

    Great summary article.

    We are headed for a worse version of the GFC where the banking system simply stops working overnight (or over a weekend).

    To mind the best system is where the players have to bear the market risk, ie small banks limited by either assets or market capitalisation no government backing and government owns the transfer system. If a bank fails the shareholders and depositors wear it. Making CEOs go to jail is also a preventer if enforced. Bank research shows that there are very limited returns to scale once past a certain point.

    Securitisation should probably be outlawed, it simply ends up being an area for gaming where the banks end run the regulators. A bank makes a loan it keeps and wears the risk.

    I would also like a hard cap LVRs on property and other transactions as that avoids other systemic risks.

    CBA at $100bn market cap is the very definition of a too big to fail bank that poses huge risk to our financial system. What are its assets now?

    • Jackson says:

      Agree, four pillars is nowhere near enough, id they need to resort to gaming the system to stay alive then the stability is highly questionable.

      • V says:

        I thought in reality we were running a one pillar system now, with that pillar extending up Swannys back passage?

  5. Explorer says:

    Withdraw the implied backing but offer a government guarantee at an additional price that makes the yield equivalent to government paper of similar duration.

    Let the wholesale and corporate markets decide if they want government risk at government yields or bank risk at bank yields.

    At the same time set up the mechanism and calculations to “bail in” quasi capital and tier 2 capital then debt of more than 12 months remaining duration.

    Do away with all security other than to the central bank in a liquidity crisis.

    The rationale is:
    1 protect the taxpayer
    2 avoid moral hazard
    3 reward risk appropriately
    4 protect depositors up to say 250,000 per institution with a maximum of say 4 tranches for superannuation fund depositors (looking through to individual account holders).

  6. China-Bob says:

    Many years ago was one of the hedgeies “rocket scientists” my job was to develop dynamic “on-the-fly” methods for stabilizing the derivatives trading algorithms. From a purely technical perspective it was challenging, to say the least. Many of the stabilizing algorithms were real cutting edge stuff, using forms of decimated non-uniform sampling and a type of correlated non-linear energy spreading.

    This was what drove the trading algo’s , so you can imagine my horror when a few years later Gaussian copulas emerged as the preferred VAR tool for CDS trading. I spoke with one of the principles and was told that everything was working perfectly no need to worry. What he didn’t seem to understand is the very concept of non-linear spreading as a damping tool only works if the quantities are uncorrelated. In “black swan” events the whole market is correlated so down is down for everyone. For this reason during black swan events you need to revert to a simple linear over-damped stability algorithm. Unfortunately these are precisely the times when huge gains / losses can occur, so instead of reverting to an algorithm that slowly exited the market they elected to use a “circuit breaker” method to dump everything completely exiting and returning to trading only when conditions normalized.

    I still occasionally chat with some of my old colleagues in the quant algorithm business, mostly they just shrug when I mention stabilizing the market during extreme events. Not my job is the most common refrain, “last guy to cash is the bag carrier”. From what I can see central banks are becoming the preferred cash for trash swap center. Unfortunately I can’t see where they are being rewarded for their default “bag holder” status.

    • Peter Fraser says:

      It’s the role that they have been forced to assume. Politicians want the brakes off lending to stimulate the economy, so we have to have “air bags” for that big fast stop.

      In the final analysis, it’s everyones fault, and so everyone has to pay.

      • Deep T says:

        Whilst others may pass off your comments as constructive. I do not

        It is neither everyone’s fault nor appropriately the cost that all taxpayers must pick up.

        The benficiaries of reckless credit expansion and unpiad for government support, like yourself, at the expense of future generations may feel self entitled, but to actually blatantly preach that all must pay is not something that I and many, many others will not accept.

        By all means make comments but dont try and throw your delusion down our throats

      • littleguy says:

        Agree. And it is a huge leap to claim it is everyone’s fault.

      • Peter Fraser says:

        Then perhaps you should read business 101.

        I don’t care whether or not you find my comments informative, it’s not a concern of mine.

        Any business that can’t pass on all their running costs and put a margin of profit on top of that will fail under any system.

        You could have argued that the cost should be deducted from shareholder profits, but we both know that the management try to build dividends and eventually they will absorb costs and either maintain dividends or build them back to former levels if there is a short term fall.

        We see a similar effect when business is forced to pay for other costs for benefits deemed by society as beneficial – I could tell you that those costs are not passed back to consumers, but it would be untruthful, so I won’t.

      • The Patrician says:

        *For more information on “business 101″ Deep T, please see the previously referenced UARE curriculum.

      • Peter Fraser says:

        The issue of fault, is political, and who votes for them?

        Everyone benefits from a strong economy in the good times, and a necessary ingredient in the economy is a responsive banking sector. That has risks, and when thosr risks go wrong, all who profited must share the cost and the blame, and that is everyone including you and I.

        It’s normal practice for everyone to run around in circles pointing fingers at everyone else, but that gets tiring after a while, so it’s best to be honest about it.

      • littleguy says:

        Nonsense, what you are doing is the equivalent of blaming the children of thalidomide for what happened to them. You are being dishonest here trying to shift the blame.

      • Peter Fraser says:

        A minor point, but the tests that showed thalidomide to be at fault were themselves discredited.
        You are denying the reality that in an upbeat economy everyone profits from that bouyancy, whether or not they contributed.

      • littleguy says:

        Just because some people got some minor run-off benefit doesn’t mean they are responsible for the ones who took the risks and got most of the benefit during the good times. You are trying to tar everyone with the same brush and that is dishonest.

      • Peter Fraser says:

        I am never dishonest. You can tell me I’m wrong as I sometimes am, but I take umbrage at that term.

      • China-Bob says:

        Actually I can see what PF is saying, because today’s banking environment is much more complex than the staid environment the Basel seems to address.

        The Hedge funds form the leading edge of the shadow banking sector, these guys are often very under capitalized but very aware of the possibility of systemic fluctuations creating liquidity events. So they are fast movers. From my experience at the next level of shadow banking you have a many players that are simply not nimble enough and trade in such a grab-bag of mixed financial products that they can’t hope to understand the follow-on effects of correlated risk in individual equities / partners. At the next level counter-parties becomes an unquantifiable risk that can change dramatically with minor movements in the market. At this level the product mix hedging strategies can fail completely creating this flow through multiplying effect on counter party risk.

        IMHO all derivatives markets, trading instruments more than two levels removed from the underlying bonds and equities, have not got the foggiest idea what their real worst case risk is. In this sense they can only operate when they know that the deep pockets of a central bank are available. This implies “cash for trash”

        Now we can argue about the value of the whole shadow banking sector, but isn’t that pointless because the sector exists. From my limited experience pragmatism is a much stronger force in modern banking than is idealism, so the whole financial system needs the strong stable force that only a can provide. Unfortunately somewhere in the process we completely leapfrogged the whole “moral hazard” concept and gave the central banks two distastefull choices, accept insane instability or underwrite the system.

  7. China-Bob says:

    I wrote a rather long reply supporting PF because the today we have the complexity of the whole shadow banking system dumping their risks back onto the main street banks have no real way to understand the correlated liabilities (and counter party risks) of their individual products / portfolios so it is understandable that they too want to find a deep pocket to support their risks.

    I think the only valid solution to this problem is to return to a system where bankers are personally liable. Personable liability has a way of transforming this nebulous concept of “counter party risk” into something far more concrete.

    • Peter Fraser says:

      Thanks China Bob – I really don’t have the answers, but I know that a syatem that encourages banks to take on risks and then penalises them for taking on those risk, isn’t a workable solution, and we will all pay.

      We either accept lower growth and less risk, or accept occasional failure.

      • China-Bob says:

        I’m not sure I agree, there are plenty of examples of Insurance systems where wealthy individuals were personally liability for all the risks of the business. Lloydes of London comes to mind, where peers were liability. It is this guarantee that made e Lloyds contract valuable.

        Derivatives contracts are replacing many aspects of insurance but without providing the financial strength guarantee that is the back-bone of real long tail risk insurance. It goes without saying that Insurance is a fantastic business IF you can avoid (or somehow average) the long tail risks. Unfortunately the current system is like a contractual fraud where everyone thinks they are somehow insured but in actuality there are no assets maintained within the system, so the first serious shock craters the whole system.

        Deep pockets and a form of personal liability is still what is basically offered by Berkshire Hathaway, in the sense that all of the principals wealth is on the table. So this old world system still exits and still garners the respect it deserves, as shown by the way GS’s stock was stabilized when Warren gave it his stamp of approval.

        I’m not at all sure how you blend the old world finance with its new ******* child, but I think it needs to start by requiring greater capital adequacy when counter-party risk cannot be properly quantified. This step alone will remove the banking communities desire to trade in obscure grab bags of derivatives of derivatives funded by obscene levels of leverage.

      • Peter Fraser says:

        Good points, but I didn’t see any of those exotic lending instruments here, although I know they were rife in the USA, and they were far more toxic that people realise.

        I would be interested in any examples if you are aware of any. In the business arena, lending covenants caused a lot of problems for those like Eddie Groves of ABC Learning – unsophisticated players weren’t used to those clauses in mortgages or loan contracts, but still they were hardly toxic instruments of debt.

        My comments were on the local market.

        I don’t have a problem with greater accountability, but any added running cost is passed onto the consumer.